What's the Real Risk?
Which would you choose?
Editor's Note: Minyanville is a community of people who share an interest of fiscal literacy. As perspective is an important aspect of our daily routine, we share this email with hopes that it adds balance to your process.
It seems to me that nearly all of the options selling that you describe is the selling of calls via the buy / write strategy.
If that's the case, isn't the real risk that the market moves much higher than anyone anticipates?
Or are you seeing a lot of put selling too?
Appreciate your insights.
Let's look at a trade that was done today and then I will let you answer that question.
A dealer out of London bought JP Morgan (JPM) stock at $35.75 and sold the January 2006 calls at $.80. We can assume that they did this to hedge a structured note sold to retail (I have good information on this). We can also assume the dealer wants to make money, so the terms passed through to the investors could not be better than this trade, but to be conservative let's assume that they were the same.
Now let's look at two scenarios: 1) the stock rises 15% (through the strike) to $41, or 2) the stock declines 15% to $31.88 from current prices.
Under scenario 1 the investor's return is: ($.80 (the call premium) + ($37.5 - $35.75) (the capital appreciation in the stock up to the strike) + $.34 (assume one dividend as the second may not be earned as the option may be called)) / ($35.75 - $.80) = 7.3%. The annualized return is 8.2% x 365/184 = 16.4%.
Under this scenario the stock is called away and the investor is left with no position while making a decent return.
Under scenario 2 the investor's return is: ($.8 + ($31.88 - $35.75) + $.34 +.34 (assume both dividends)) / ($35.75 - $.80) = -6.8%. The annualized rate of return is = -13.6%.
Under this scenario the stock remains in the investor's hands.
So which scenario do you think would cause the most consternation? Scenario 1 where the investor has no position left and made a nice return, or scenario 2 where the investor has lost a fair amount and still has risk?
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter